Examining Monetary Neutrality in Short-run and Long-run Considering Monetary Shocks in the Economy of Iran: Applying Bounds Testing Approach

One of the main subjects for all policy-makers at the macroeconomic level is to investigate the behaviour of economic variables in the short-run and also in the long-run as a result of a change in policy parameters. Monetary policy parameters are among the main policy parameters which are studied in this paper. One of the main subjects in the literature of theoretical economics is to study the channels through which monetary policy and monetary-policy-shocks affect the real variables.
Theoretical Framework
There is a proposition in macroeconomics, which dates back to David Hume literature, and says money is neutral. Neutrality of money means that changing the stock of money affects only nominal variables such as prices, wages, and exchange rates while it has no effects on real variables like real GDP, and real consumption and employment. Neutrality of money implies that the central bank will not create more jobs by printing money. It also means that a change in the money supply will not affect the size of real GDP in the economy. Almost all economists around the world agree that neutrality of money holds in the long run. However, things are much more complicated in the short-run and there is no agreement on this between economists. Classical economists introduced neutrality of money based on classical dichotomy and their main focus was on long-run. Keynes (1936) rejected neutrality of money and introduced demand-side management to stabilize economy. Assuming this, Keynes believed that money is not neutral in the short-run. Monetarists led by Milton Friedman, by assuming adaptive expectation and distinguishing two versions of Philips Curve, one for the short-run and the other for the long-run, claim that money is not neutral in the short-run because economic agents confused by money illusion always respond to changes in money supply with a delay which is the source of mistake for economic agents and a base for any successful demand-side management policy in the short-run. New classical economists led by Robert Lucas, by assuming rational expectation and accepting the equal information sharing among all economic agents and removing the information advantage for the central bank, returned to the classical world of neutrality of money. However, they believe that only unexpected monetary policy will affect the real variables but central bank's ability to use countercyclical stabilizing monetary policy is limited because the central bank has no advantageous information over other economic agents, and also, it will not always be able to deceive people to achieve its goals (Maccallum, 2004). New Keynesian economists by searching microeconomic foundations for old Keynesian theories believe that monetary policy is not neutral but the impact of monetary policy during business cycles are asymmetric (see Ball & Romer, 1989, 1990; Ball & Mankiw, 1994a, 1994b; Cover, 1992; Ravn & Sola, 2004).
Neutrality of money has been a main research question in the last century. This paper studies monetary neutrality and asymmetric response of the economy to monetary-shocks using quarterly data during 1990:2-2014:4 in Iran and applying Bounds testing approach (Pesaran et al., 2001) and Hodrik-Prescott filter (Hodrik & Prescott, 1997) within ARDL framework.
The results show that money is neutral in affecting the output growth in the long-run but it affects output growth in the short-run in the economy of Iran. Moreover, Hodrick-Prescott filter was used to separate positive and negative monetary shocks and to draw business cycles for the Iranian economy. The results confirm that the monetary-policy-shocks have asymmetric impact on output. The results also show that the monetary-policy-shocks have asymmetric impact on output during business cycles.
Conclusion and Suggestions
The general conclusion is that the monetarist view which says that money is neutral cannot be rejected in the long-run for the economy of Iran. Therefore, the role of money in the economy is consistent with the monetarist view. In addition, the New-Keynesian view that concentrates on asymmetric effects of monetary shocks on real GDP during business cycles cannot be rejected. Therefore, the impact of monetary policy and monetary shocks during business cycles on the GDP are asymmetric for the economy of Iran. Based on our results, we suggest that the central bank should be more aware of these asymmetric effects of monetary policy and monetary shocks on the economy of Iran and consider them in any policy package for a better and more successful monetary policy.